A Sea of Liquidity

Will the Fed institute QE3, extend QE2, or shrink its balance sheet?

Recent weakeconomic data have ignited a debate. Should the Federal Reserve start a new round of quanti­ta­tive easing (QE3) to ensure the economic recovery, or is it time to let the market determine interest rates and let economic chips fall where they may?

With QE2, which expired in June, the Fed purchased $600 billion of longer-term Treasury securities and reinvested principle payments from its holdings of agency debt and agency mortgage-backed securities to the tune of $300 billion during the last eight months. The result: The monetary base (the Fed’s balance sheet) ballooned to $2.6 trillion in May, up from $2 trillion only five months earlier.

QE2 has created a sea of liquidity and contributed to the lowest interest rates since the 1950s. Depository institutions are now sitting on $1,513 billion in excess reserves, up from
$2 billion in May 2008.

Those supporting QE3 point to recent weak economic data, including:

First-quarter 2011 gross domestic product growth came in at a disappointing 1.8%;

Personal consumption growth has slowed;

Initial jobless claims have again moved above 400,000;

May job growth was only 54,000;

Home prices fell 4% to 5% from May 2010 to May 2011; and

The Institute for Supply Management’s manufacturing survey index dropped nearly seven percentage points from April 2011 to May 2011.

If the Fed doesn’t purchase Treasury securities (reducing the supply in the open market), interest rates across the maturity spectrum could increase significantly, crushing the still-fragile economic recovery and potentially leading to a double-dip recession.

Those opposing QE3 believe the Fed has injected more than enough liquidity into the financial system to keep credit flowing freely to credit-worthy businesses and consumers. They worry some of the liquidity has made its way into emerging markets and speculative activity in the commodity markets.

Opponents argue excess liquidity might be working against the Fed’s full employment mandate. They blame the increasing money supply for the dollar’s falling value and increasing import and commodity prices. The oil price increase is one factor blamed for the slowing economy and increasing unemployment.

When determining monetary policy, the Fed analyzes the marginal benefits and marginal costs of each conceivable action. Fed Chairman Ben Bernanke says the bar will be set very high for any additional quantitative easing: “The trade-offs are getting less attractive. It’s not clear we can get further significant improvement in payrolls without inflation risk.”

The Fed knows not to take any one month’s economic data and extrapolate the future from it. Recent weak economic data was caused mainly by transitory factors: poor weather, Japan’s supply chain disruptions, and increasing oil prices.

It’s unlikely the Fed will move forward with QE3. But if the current economic soft patch continues, it might be unwilling to let its balance sheet shrink as its mortgage and Treasury securities pay down. It might, instead, decide to reinvest all repayments—in essence, to extend QE2.